Novum Alpha - Daily Analysis 29 March 2021 (10-Minute Read)
Nonetheless, markets are likely to get off to a shaky start this week as traders tally up the body count from last Friday's sharp selloff.
A magnificent Monday to you as markets remain shaken by the massive block trade sales last Friday from the margin calls against a significant family office.
In brief (TL:DR)
In today's issue...
You know what's more risky then gambling? Gambling with borrowed money.
And those bets taken by former hedge fund manager Bill Hwang, who was indicted in 2012 for insider trading and who now runs a family office, are now starting to blow up real fast.
On Friday, some US$20 billion worth of shares were alleged to have been forced sold by banks which had extended credit to Hwang's Archegos Capital Management, rippling through the wider market for the sectors that Hwang was bullish on before it became apparent that the unwinding was specific to him and not industry-wide.
Nonetheless, markets are likely to get off to a shaky start this week as traders tally up the body count from last Friday's sharp selloff.
In Asia, indices came out mixed, largely betting that the block trade sales on Friday can be contained, but choosing not to take overly bullish positions with Tokyo's Nikkei 225 (+0.72%) up, while Seoul's Kospi Index (-0.17%), Sydney’s ASX 200 (-0.23%) and Hong Kong's Hang Seng Index (-0.05%) all lower in the morning trading session.
1. The Mysterious Man Behind the Mysterious Block Trades
As US$35 billion was wiped off the market cap of some of China’s most promising tech firms as well as specific U.S. media companies last Friday, word on the Street was that a hedge fund had closed.
Worse, it was a family office with significant bags and leverage to the eyeballs, that was facing a margin call.
Bill Hwang, a former hedge fund manager who’d pleaded guilty to insider trading in 2012, had spent the better part of the past decade trying to rehabilitate his image.
As Hwang was doling out millions of dollars in commissions to rival dealers, Goldman Sachs (-0.96%) refused to sign him up as a client, even though Hwang’s family office was larger than some hedge funds.
All that changed sometime in 2018, when Goldman Sachs possibly felt that Hwang had been in the doghouse for long enough, and extended credit to Hwang’s Archegos Capital Management to lever up bets on firms like Chinese tech giant Baidu (+1.97%) and media conglomerate ViacomCBS (-27.31%).
But like an episode of the Showtime series Billions, Goldman Sachs reversed its bet on Hwang and executed one of the greatest margin calls of all time, forcing Hwang to unwind his giant portfolio in a messy and painful liquidation, with years of litigation likely to follow from this.
On Friday, Archegos Capital Management was allegedly forced to dump over US$20 billion worth of stocks, in a manner that was so hurried, markets scarcely had time to react.
Traders initially thought that the Chinese tech sector was crashing when rumors later circulated that it was a hedge fund that was closing down, but it eventually surfaced that it was a family office that was being cut off from credit.
The massive margin call by Goldman Sachs triggered a cascade of other banks calling in their loans to Archegos Capital Management, and algorithmic traders sent the stocks of firms held by the family office plummeting.
To be sure, none of the companies that Hwang had picked were doing particularly well anyway.
Both ViacomCBS and Discovery Communications (-27.45%) had suffered a fresh analyst downgrade as they announced their forays into the highly competitive and increasingly saturated streaming market, despite lacking a breadth of content that rivals such as Netflix (+1.03%) possess.
And while that may have provided the pretext for Goldman Sachs to pull the rug from under Hwang, the true motivations for the messy margin call may never be known.
What is known is that the margin call was premeditated and planned – with Goldman Sachs emailing clients late on Friday to inform them that it had been one of the banks selling Hwang’s positions.
But Goldman Sachs was hardly alone in making a margin call on Hwang, with banks who had previously courted him for commissions now declaring Archegos Capital Management in default, and messily liquidating huge blocks to recover their capital.
As the U.S. markets open later, the bloodbath is likely to continue for sometime longer and whether it will take the entire tech and media sector with it is anyone’s guess.
2. Bubble? What Bubble?
“It’s beginning to look a lot like a bubble,
every metric you know,
take a look at a firm’s P/E,
isn’t it quite frothy?
But who cares when the Fed will let if flow?”
- Sung to the tune of Bing Crosby’s “It’s Beginning To Look Like Christmas” and written by Meredith Wilson © 1951
For every traditional valuation metric that suggests stocks (or cryptocurrencies or whatever risk asset you can find) looks frothy, there’ll be another that denies assets are overpriced.
Whether it’s forward P/E or the so-called Buffet Indicator, there’s a metric for anyone crying wolf on the market and just as many pointing to the boy who cried wolf.
But markets are in uncharted waters – it’s entirely possible that the old standards and metrics no longer apply, when something as unprecedented as a pandemic is behind the stress.
Yet the pandemic cannot be blamed for everything and many a portfolio has been pillaged through complacency, with market veterans often warning of fortunes lost by investors seduced by the seductive siren call of “new rules and paradigms.”
A German proverb which postulates that trees do not grow to the sky should be instructive – can markets truly outlast even the most deluded optimist?
But when even the most skeptical economist suggests that markets still have room for upside, should we batten down the hatches and hoard cash or make one more punt?
Yale University Professor Robert Shiller is famous for his unpopular warnings of both the dotcom and housing bubbles, using his cyclically adjusted price-to-earnings ratio that includes the last 10 years of earnings.
And while Shiller’s tool is now flashing warnings that stocks are overvalued, Shiller himself seems to disagree, writing in a recent post that “with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.”
Consider that each time car performance has increased, automakers have had to add more digits to the end of the speedometer – it is possible for stocks to reach higher highs, with even Goldman Sachs strategists arguing that regardless of how high P/Es are, the absence of significant leverage outside the private sector and a late-cycle economic boom points to low risks of a bubble bursting.
Perhaps it could also be that the pandemic has made investors of us all.
Today, more Americans own stock than at any time in history – and user-friendly zero-fee trading apps like SoFi and Robinhood have sparked off a revolution in who an investor is.
Gone are the staid suits of your broker at Charles Schwab (+0.89%), instead, retail investors are looking to financial advice gleaned from the likes of Twitter (+0.11%) and Reddit.
And even though bond yields are spiking – they may have found their equilibrium after a tepid auction for 7-year U.S. Treasury notes saw only a marginal increase in yields – bond traders are shaken, but not stirred.
More importantly perhaps, corporate America is emerging from a recession, with profits forecast to stage a strong comeback.
Even though the S&P 500 is trading at 32 times reported earnings (which looks pretty expensive), with income forecast to jump by 24% this year, that multiple quickly drops to 23, which is comparable to the best of Europe, but without the prospects.
But while rock-bottom interest rates (almost guaranteed to 2023) underpin many of the arguments as to why stocks have a chance to continue heading northwards, risks are mounting the higher those trees head towards the cloud.
And valuations are never useful to time the market because expensive stocks can always get more expensive (sort of like Veblen goods) and as was the case during the housing and dotcom bubbles.
Longer term though, valuations do catch up and the more over-valued the market is, the lower the future returns (they’ve all been cashed in already).
3. How Does DeFi Deliver Those Crazy Yields?
For the uninitiated, the head-spinning yields from cryptocurrency lending and liquidity provision on decentralized finance or DeFi platforms can sound like the stuff of a Ponzi scheme.
Yet a closer examination of how these yields are generated reveals an almost zero risk trade – lend U.S. dollars to hedge funds so that they can buy Bitcoin and take double-digit interest rates off the top for your service.
Some of the largest non-banks in cryptocurrency are stepping up to meet investor demand for dollars amid a long-standing wariness by traditional banks to lend to individuals or companies associated with Bitcoin or other cryptocurrencies.
Even MicroStrategy (+0.50%) had to issue a convertible bond to raise the money it wanted to use to buy Bitcoin – an issuance which was wildly oversubscribed.
But because there’s a huge cash shortage for hedge funds who want to buy Bitcoin, cryptocurrency firms are generating annualized returns as high as 40% to lend those dollars to buy an asset which they will benefit from should it appreciate.
Here’s how the trade works – it starts with what’s known as a “basis trade” – the difference between the current spot price for Bitcoin, and the value of a derivative contract that will be due months in the future.
For instance, the price of Bitcoin today is US$55,558, while the July future contract on CME Group (+1.55%) is for US$57,635.
A hedge fund could buy Bitcoin at today’s spot price, and sell the July future contract (the right to buy), which would mean that the derivative would gain value, if the price of Bitcoin fell.
Doing so today would lock in a 4% spread between the cash and futures price, and annualizing that return between March 29, 2021 and July 30, 2021, when the futures contract expires, equates to a 12.34% annualized return.
Meaning that a hedge fund which could borrow, even at an exorbitant rate of say 5%, could still see a positive carry of 7% profit on the trade.
And while the spread between the spot and futures is low today, it has been high in recent history, with some basis trades paying as much as over 40% annually.
More importantly, the trade is almost risk free – assuming that CME Group doesn’t go bust as a counterparty – because once the spot and futures prices are locked in, they will converge so that the spread between them is the payoff, less trading fees.
Ironically, for all the dollars in the financial system that are struggling to get even 4% per year, the double digits in the DeFi system can’t even get a buck.
And until those dollars find a way to trickle into the cryptocurrency financing system, these spreads will continue to exist, and lenders in the space will continue to outperform their traditional counterparts.
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Mar 29, 2021
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